Are You Flying Below The Tax Radar?

Like a flight controller or a meteorologist, the IRS keeps an eye on the blips that show up on its monitoring screen when your income, tax payments, and investment activity are reported. There may be nothing you can do about much of that. However, by carefully monitoring the activities within your portfolio, you might manage to fly "under the tax radar." That could save you hundreds or thousands of tax dollars when you file your return.

Here's what we mean: The tax law provides certain thresholds for triggering higher taxes. Once you clear a threshold, you must pay tax at a higher rate—but stay below it, and you'll pay less. This can involve any of several tax provisions:

Ordinary income tax. The graduated rate structure includes seven tax brackets ranging from a low of 10% to a high of 39.6%. Once you exceed the threshold for a new bracket, any additional earnings will be taxed at that higher rate. For 2014, the threshold for the 39.6% rate is $406,750 for single filers and $457,600 for joint filers.

Pease/PEP limits. Under the Pease rule, most itemized deductions—including those for charitable donations, state and local taxes, and mortgage interest expenses—are reduced to the extent that your adjusted gross income exceeds an annual limit. A comparable tax rule—called the personal exemption phaseout (PEP) rule—reduces the tax benefits of personal exemptions. The threshold for the Pease/PEP rules in 2014 is $254,200 for single filers and $305,050 for joint filers.

Net investment income tax. The 3.8% Medicare surtax applies to the lesser of your "net investment income" (NII) or the amount of your modified adjusted gross income (MAGI) that exceeds an annual threshold of $200,000 for single filers and $250,000 for joint filers. Although NII includes most income items, others, such as distributions from IRAs and workplace retirement plans, are specifically exempted. Nevertheless, those distributions still increase your MAGI for this calculation.

Flying below the radar involves closely watching these thresholds and trying to maximize your "tax bracket management" (see chart). For instance, you might invest in tax-exempt vehicles such as municipal bonds or in tax-deferred investments such as growth stocks or annuities to keep your current taxable income below a threshold. Similarly, if you find you have some leeway before you hit the next bracket, you might consider filling that space with income you generate by converting a traditional IRA to a Roth IRA—a move that could reduce future tax bills. But for maximum effect in staying under the radar, try to look at your portfolio from a horizon of at least five years.